Microeconomics: Making Economic Decisions - Starting A Business
by Marc Davis
The microeconomic concepts that drive the decision-making processes of an established firm are also applicable to a start-up business.
A major difference, however, is that the small start-up, in the beginning, will not usually have enough, if any, accurate data on supply and demand upon which an established business makes its decisions on pricing and output.
Microeconomics: Microeconomics in Action
Keys to Success
Data shows that four out of five new business ventures fail within the first five years of opening. There are many causes for these failures, including inadequate financing, a poor business plan, an inability to compete in a difficult market, too much total debt, and occasionally, as the Small Business Administration (SBA) has reported, "Sometimes businesses close because the owners lose interest, or because they realize they would prefer to work for someone else." (For more on this, read 4 Steps To Creating A Stellar Business Plan.)
"The key predictors of success haven't changed, though," says the SBA. "Businesses that have employees and that have good financing tend to survive longer."
Another key predictor of success for a start-up enterprise is the advanced microeconomic research and planning conducted by the entrepreneur starting the business. (To see is you have what it takes, read Are You An Entrepreneur?)
Planning, Strategy and Supply and Demand
Before studying the microeconomics of starting a business, however, the entrepreneur should also be aware of the larger aspects of a start-up business. These include writing a business plan, a strategy, a marketing and advertising plan, and a sales program. The entrepreneur should also consider whether employees will be required, and the legal and insurance aspects of the business.
Another major concern of start-up businesses are the vendors and suppliers required, the physical premises in which the business will be conducted, and the all-important financing. Most importantly in starting a business, at least from a microeconomics perspective, is the supply-demand factor. Will there be enough demand for what the new business intends to supply? That's a critical question, and if the answer is negative, the chances that the business will succeed are minimal.
Whatever product or products, or whatever services the start-up business plans to sell, a thorough study of the potential market for those items should be undertaken before a business plan is written. (For a list of what needs to be done before opening, see Start Your Own Small Business.)
If your start-up business is positioned in a fast-growing market in which new consumers are being created regularly – clothing for teens, for example, or products for college students including the annual batch of freshmen – then demand for the product may also regularly increase. But in any age-dependent category of product, for every new customer coming into the market, an older customer will leave the market, resulting in a market that remains approximately the same size overall, but with new buyers continually coming into it.
If the new business is a restaurant, for example, or some other form of retailing, a study of the location – the neighborhood in which the business is to be located – should be conducted to determine if there's enough demand to sustain the business.
Know Your Competitors
Although accurate, detailed information about your potential consumers and competitors may be difficult to obtain, first-hand observation of activity in your competitor's establishment, talking to potential customers and watching customer traffic and volume through the week and at various times of the day will give you a rough idea of what the new business may be up against.
This "competitive intelligence" may also provide information about consumer desires and preferences – what they want that your potential competition is not providing. Knowledge of your competition's pricing is also essential. As we discussed in previous chapters, pricing, demand, marginal revenue and its relation to marginal costs, how much of a product to produce, and elasticity of demand, are all factors in which pricing is an essential element.
A microeconomic theory called "perfect competition," refers to small businesses and start-ups in which many small companies supply a single product or service. These businesses and their consumers are too small to influence the market price of what's being bought and sold, and so their prices are locked in. But perfect competition seldom occurs, and even if it does, there are numerous ways to compete other than with price.
If, however, a start-up is forced to compete on price, it can still be profitable if the start-up's profit margins and marginal revenues are adequate. This necessity requires a comprehensive knowledge of the business, effective negotiating skills and judicious decision-making. A thorough knowledge of the business you're starting will reveal where costs may be cut or contained to yield bigger profit margins.
Judgment and Decision Making
Effective negotiating skills will enable you to get the best prices from vendors and suppliers when hiring employees, and from lending institutions when negotiating the terms of your start-up financing.
Judicious decision-making will enable the start-up entrepreneur to maximize profits using the microeconomic formulas described in the previous chapter. For a small start-up that intends to enter a business category already dominated by large, established players, the challenges can be overwhelming.
Large firms can buy from wholesalers at volume discount prices. They can negotiate with unions to reduce labor costs and benefits. Generally, they may be able to secure better terms with lenders, and better credit arrangements with vendors and suppliers. Smaller firms, and especially small start-ups in which there's a higher level of risk to the lenders and to the firms that provide credit, may not be able to borrow money or obtain credit from vendors at favorable terms. (For more, see Plans The Small Business Owner Can Establish and What Are Economies of Scale.)
Large, well-established firms also possess institutional knowledge about their industry that the newcomer does not have. The larger firms may also have greater cash reserves to weather market downturns, or unforeseen problems that may compromise profitability.
A small start-up will have few if any of the advantages cited above, and will therefore find it very difficult, if not impossible, to compete against large, dominant firms. Unless an entrepreneur has a unique and effective means of battling these daunting odds against success, he'd be well-advised to start a different category of business. (To learn about how the little guy can beat out big competition, see the answer to your frequently asked question How did Dow Chemical defeat an international monopoly in the 1900s?)
Still, small, independent restaurants, as just one example, compete successfully against giant fast food chains such as McDonalds (NYSE:MCD), Wendy's (NYSE:WEN) or Burger King (NYSE:BKC). The successful independent restaurant or diner offers unique elements to the consumer that are unobtainable at the majors. These could be convenience of location, menu specialties and a wider variety of choices, a friendlier ambience, a higher quality product, or even competitive pricing.
As a start-up business grows and matures it begins to face the same microeconomic decisions that an established business confronts. The same decision-making processes described in the previous chapter then become necessities and the same rules apply.
The longer a small start-up survives, the more data it will acquire on supply and demand, price elasticity, marginal revenues and marginal costs, and other important data. Adjustments in planning can then be made to produce a better bottom line for the firm.
Assuming a start-up is profitable, the problem of taxes then arises. This is an obvious point, but worth mentioning anyway - the government will want its share of your profits and a smart, experienced accountant with expertise in taxes should be employed to make sure you keep as much of your hard-earned money as possible, and legally, of course.
In gathering information as part of your start-up planning, the government and various trade associations may be able to provide valuable data. Government sources of consumer information include the U.S. Department of Commerce, the Small Business Administration, and the Small Business Answer Desk.